Friday, January 25, 2013

NGDP Targeting re-frames the Inflation Targeting debate

One of the biggest casualties of the global financial crisis may be the use of Inflation Targeting (IT) as the dominant monetary policy strategy. With IT having failed to avoid the crisis and now not being able to help economies out from the depths of deflation, governments and central banks look set to give IT a honorable burial. As the graphic below shows, prevailing inflation targets provide no guidance for monetary policy for countries seeking help to exit deflation.
Nominal Gross Domestic Product (NGDP) targeting is emerging as one of the strongest alternatives to IT as a monetary policy framework. As the name suggests, it projects the trend growth rate of nominal GDP as the monetary policy anchor. By subsuming inflation within the NGDP target, it avoids getting entangled in the inflation debate.

Scott Sumner has an excellent article where he lays out the defence of NGDP targeting. In making out the case for NGDP, Scott Sumner points to its greater popular and political acceptability, apart from its greater inherent effectiveness. In particular, he points to the difficulty with getting support for policies that explicitly seek out inflation in order to recover from a deep deflationary environment due to the entrenched belief that all inflation is bad. In this context, NGDP targeting provides a nice behavioral psychology sleight of hand by re-framing the debate in terms of raising nominal GDP and job creation instead of generating inflation.

Paradoxically, cognitive biases arising from our aversion to inflation and affinity for output growth, causes us to oppose expansionary policies which cause inflation while supporting those that promote growth, despite both outcomes being two sides of the same monetary policy coin (the effect of expansionary monetary and fiscal policies get distributed between inflation and growth, the relative magnitudes of each being dependent on supply-side factors). This is a classic example of how framing the terms of a debate can increase political acceptability of the same policy instrument. As Scott Sumner writes,

If we stopped talking about inflation targeting and started talking about NGDP targeting, we could greatly simplify the policy debate. Do we want more demand, or not? Most Americans surely think that more demand would be a good thing right now, but very few people want to see more inflation. To the Federal Reserve, these two effects are simply two sides of the same coin. But because the Fed expresses its aims in terms of inflation, its work is understood as a matter of managing inflation, and therefore Fed policies aimed at boosting inflation are politically problematic.

NGDP targeting therefore provides a cover for expansionary monetary policy, which has been stigmatized by its close association with inflation, to play its full role in growth by reducing the focus on inflation. It frames the terms of the debate as between growth and stagnation, not higher and lower inflation.